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BlackRock Bloghttps://dzog4p0nj4wky.cloudfront.net/content/themes/blackrockblog/images/logo-blackrock_blog.png?v=3Monetary Policy in 2019, the pause that refresheshttps://www.blackrockblog.com/2018/12/19/monetary-policy-2019/
https://www.blackrockblog.com/2018/12/19/monetary-policy-2019/#respondWed, 19 Dec 2018 06:35:57 +0000https://www.blackrockblog.com/?p=43805If you’ve ever endeavored to furnish a new dwelling, chances are you’ve faced the daunting task of installing a large wall fixture, perhaps a mirror or painting. The dreaded process entails extensive choreography with multidimensional measurements, access to the requisite tools, and a willingness to embrace the reality of numerous unsuccessful attempts and unsightly holes in your living room wall. Eventually, after wrestling your fixture onto its hook, you need to step back from the wall for a better perspective–a pause in your process to ensure that your laborious undertaking has achieved an optimal outcome. To us, the Federal Reserve’s ongoing efforts to seek policy neutrality are a similarly painstaking and imprecise exercise, and that recent market tumult, alongside a deceleration in growth and inflation, provides sufficient reasons for the Fed to step back and ponder their efforts to date before acting further.

The evolution in global liquidity

Conventional wisdom says that 2018’s market contagion is unjustified relative to the de minimis absolute level of cyclical policy tightening relative to history. To us, it’s not the absolute level of tightening that’s causing consternation, but the stark contrast of today’s aggregate policy posture versus this time last year. In the fourth quarter of 2017, global liquidity was growing at its fastest pace ever: developed market real policy rates were negative, China was enjoying the tail-end of a multi-year credit explosion, and the U.S. was set to unleash powerful fiscal stimulus, a global policy cocktail that was perhaps amongst the most supportive postures of recent years for risk assets (see graph).

Today, global liquidity is in steady decline, U.S. real policy rates are the highest levels in almost a decade, China is endeavoring to deleverage, and U.S. fiscal stimulus is set to abate. Moreover, U.S. Treasury supply has doubled from last year. This sudden policy U-turn is creating a two-fold systemic shock to the financial economy: the newfound availability of positive real-yielding risk-free securities, along with the significantly higher discount rates that need to be applied to risky cash flows, are crowding investors out of risky assets.

Many financial prognosticators stubbornly adhere to a forecast of significant additional policy tightening, even though markets are increasingly loath to price in that hawkish path. At this point, at least, we agree steadfastly with the markets and hold the view that we’re at the doorstep of policy neutrality and a Fed pivot toward a more symmetric, and data-dependent, forward policy path is at hand.

Decelerating global growth is already apparent in both high frequency macro data and messaging from globally exposed corporations, as evidenced by sharply decelerating revenue, contracting margins and slower cash flow growth. More importantly, U.S. inflation has struggled to achieve the Fed’s desired target, as secular inflationary headwinds remain firmly entrenched. For instance, ubiquitous technological innovation is enabling profound production efficiencies across every sector of the economy, from energy to retail. Further, the continuing evolution of cloud computing and data storage is driving a shift out of traditional corporate capital expenditure and into research and development, as companies race to build out machine learning and artificial-intelligence capabilities, or risk being left behind by more effective and lower cost competitors. We are still in the early stages of these generational deflationary trends.

Are rising wages a spur to higher prices?

Meanwhile, considerable ongoing debate exists about the degree to which accelerating wage growth will catalyze inflation as it sometimes has historically – a relationship we think has broken down. Counter to historical precedent, rising wages are in fact paradoxically dis-inflationary today. The relentless assault on corporate pricing power by information symmetry (think Amazon and user reviews) is forcing corporations to absorb rising wages through narrower profit margins, instead of pursing higher prices. As cash flows are squeezed, animal spirits are dampened and economy-wide activity slows. Further, today’s wage earners have a demonstrable proclivity to save their rising wage windfall rather than divert it to incremental consumption. In total, rising wages are a virtuous societal phenomenon rather than a harbinger of inflation; a source of stabilization for a real economy that is flirting with systemic capacity constraints. Therefore, wage gains should be embraced by policy makers today rather than extinguished.

Further, the relationship between risky assets and inflation (or real rates) is neither linear nor exponential, but parabolic. Risky asset valuations get hurt when inflation and real rates are either too low or too high. At the apex of that parabola is an optimal scenario where risk valuations flourish – and our demographic models of potential growth and inflation suggest that that apex is shifting to the left (in other words, risk assets flourish now at a lower level of inflation and real rates than in decades past). Most likely, the optimal risk-free rate has already been achieved, as evidenced by risk assets’ struggles during 2018’s “year of adjustment,” and incremental increases from here are unwarranted. Thus, with the cyclical increase in rates now completed, portfolio balance can be restored anew and duration can once again be employed as an effective hedge for risk, making “risk less risky.”

Investment implications

This new equilibrium rate plateau is far higher than anything experienced during the post-crisis era. As a result, one of our favorite regime identification tools is now flashing a more cautious signal. For several years the persistence of ultra-low rates meant that discounting corporations’ free cash flow using their cost of financing revealed inherent cheapness down the capital stack. Today’s higher rates and spreads have caused much of that “value” down the capital stack to evaporate, and we’re duly adjusting our portfolios.

In 2018, long Treasuries posted a negative return, causing balanced portfolios of stocks and bonds to experience their only year of under-performance versus cash in at least half a century, outside of outright recessionary periods. The regime shift in risky versus risk-free correlation that we expect in 2019 cannot be understated: it means a portfolio of high-quality European and Japanese assets swapped back to U.S. dollars, Agency mortgage-backed securities and modest allocations to select EM and credit, could work well in the year ahead, if generously hedged with U.S. duration.

Rick Rieder, Managing Director, is BlackRock’s Chief Investment Officer of Global Fixed Income and is a regular contributor to The Blog. Russell Brownback, Managing Director, is Head of Global Macro positioning for Fixed Income, and he contributed to this post.

In August, I suggested that EM stocks were beginning to look like that rarest of things in an aging bull market: a bargain. My timing, to be generous, was early. From the late July peak to the fall bottom emerging markets equities lost another 15%.

However, more recently EM stocks have been outperforming. Given the litany of concerns, from a trade war to tighter financial conditions, why are EMs outperforming and can it continue? Three factors to consider.

1. Still cheap, getting cheaper.

Emerging market stocks were inexpensive in July; they are cheaper today. Based on trailing earnings, the price-to-earnings (P/E) ratio has dropped from 13.1 to 12, the cheapest since late 2015. On a relative basis, the MSCI Emerging Market Index is still trading at a 30% discount to developed markets, close to the bottom of this cycle’s range.

2. A more range-bound dollar.

After rallying 10% from the February low to the August high, the rally has started to stall. While the Dollar Index (DXY) did make a nominal high in mid-November, more recently the index has been stuck around 96-97. This is important. In the post crisis-world a rising dollar has been associated with weaker EM returns. Since 2010, monthly changes in the dollar have explained roughly 30% of the variation in emerging market equity returns. A flat dollar removes a key headwind.

3. Slower growth and inflation suggest rates may be peaking.

During the spring and summer a stronger dollar coincided with rising interest rates. That has, at least temporarily, come to a halt. Investors are now more concerned about slower growth. This concern is beginning to show up in inflation expectations, which have recently fallen below 2%. Slower growth and decelerating inflation may allow for a quicker end to the Fed’s tightening cycle, another factor that would likely support EM assets.

Can EM rise?

Relative out-performance is one thing, but can EM assets actually start to rally? As others have commented, one way to frame 2018 is as a series of rolling bear markets. The trend was first evident in emerging markets, but quickly spread to commodities, European equities and most recently U.S. tech stocks.

In this light, EM’s biggest advantage may simply be the fact that it got the bear market out of the way early. With the asset class now trading at its lowest valuation since the 2015 bottom and some of the key headwinds abating, any shift in sentiment is likely to be accompanied by a big EM bounce. If or when that occurs, I see best opportunities in Asia.

Non-fiction picks

Crashed: How a Decade of Financial Crises Changed the World by Adam Tooze.

This 2018 book by economic historian Tooze, a Columbia University professor, is my top recommendation. It’s a heavily researched history of the 2018 Great Financial Crisis (GFC) and its aftermath up to early 2018. Tooze revisits, and frankly debunks in my view, a number of narratives about the crisis that have become conventional wisdom. He also raises many difficult questions, such as what could stem the wave of worldwide populism that the GFC helped release.

Asia’s Cauldron: The South China Sea and the End of a Stable Pacific by Robert D. Kaplan.

Jack Aldrich, a BlackRock Investment Institute business strategist, recommends this 2014 book to anyone seeking to learn more about Asia’s rich cultural and political histories, as well about where U.S. and Chinese interests come together (and diverge). Kaplan, a preeminent thinker on geopolitics and foreign affairs, offers insights on the strategic primacy of the South China Sea that Jack says are as relevant and insightful today as they were when the book was first published.

Doing Capitalism in the Innovation Economy: Reconfiguring the Three-Player Game between Markets, Speculators and the State 2nd Edition by William H. Janeway.

Axel Christensen, BlackRock’s Chief Investment Strategist for LatAm & Iberia, said this book is on his reading list. A Bloomberg podcast interview with author Janeway on “how the unicorn bubble will burst” brought this book–and the author’s interesting perspective as both an academic and a venture capitalist – to his attention.

The Sleepwalkers: How Europe Went to War in 1914 by Christopher Clark.

This 2013 book by historian Clark, another on my holiday list, is a slow read about how the world, well, sleepwalked into World War I. While not that recent, it has come back into the spotlight lately as people draw comparisons between the period before the First World War and the current unsettled state of the world.

The Undoing Project: A Friendship That Changed Our Minds by Michael Lewis.

This 2016 book is another pick from Axel. He describes it as “a great narrative” about the unlikely partnership of Israeli psychologists Daniel Kahneman and Amos Tversky that landed them a Nobel Prize in Economics and created the field of behavioral economics.

Fiction picks

Milkman: A Novel by Anna Burns.

This 2018 book, my fiction pick, won this year’s Man Booker prize. It’s a tale of life in Northern Ireland during the late 20th century Troubles that is grim, at times very funny, and often deeply engrossing despite what some reviewers may have written (and I’ve found it doubly engrossing in the audiobook version). It’s also a timely reminder about the dangers of not letting sleeping dogs (or, in this case, borders) lie.

All the Light We Cannot See by Anthony Doerr.

Lukas Daalder, the Chief Investment Strategist for the Netherlands within the BlackRock Investment Institute, recommends this 2014 Pulitzer-Prize winning book. He read the book after listening earlier this year to a podcast from Ritholtz.com that recommended the book, though the book has nothing to do with economics. Lukas’ reasons for recommending the book: it’s well-written, with a good build-up of tension and an unpredictable ending. I also recommend this book, which I absolutely loved.

Here are lessons we draw from 2018

1. Geopolitics matter.

We had warned markets were vulnerable to temporary draw-downs in 2018 if tough U.S. trade talk turned into actions. Yet the magnitude of the impact of geopolitics on markets has surprised us. This effect on stocks is reflected in the decline in valuations in the chart above. It corresponds with a rise in market attention to the risk of global trade tensions throughout 2018 and with market concern about geopolitical risk overall remaining at a historically elevated level. This is reflected in our BlackRock Geopolitical Risk Indicators. Geopolitical risks beyond the U.S.-China trade relationship have also played a role this year in European markets and in many emerging markets (EM), where the risks have been more local.

Adapting to rising rates and building portfolio resilience

We find trade frictions are more baked into asset prices than a year ago. Yet we expect the vagaries of U.S. trade policy changes to cast a shadow over markets. Another geopolitical risk causing us worry: the risk of fragmentation in Europe. Overall, we expect further market sensitivity to geopolitical risks in 2019 as global growth slows: We find the impact of geopolitical shocks on global markets tends to be more acute and long-lasting when the economy is weakening. See our BlackRock geopolitical risk dashboard.

2. Rising short-term yields have made cash a viable alternative to riskier assets for U.S.-dollar-funded investors and have exposed markets with weak fundamentals.

Two-year U.S. Treasury yields are now more than three times their average over the post-crisis period. Rising rates hit EM assets much harder than we expected this year and led to a wide dispersion in EM returns. We see many EM assets offering better compensation for risk as we head into 2019, with the Fed likely pausing its quarterly pace of hikes amid slowing growth and contained inflation. But EM countries with large external liabilities are vulnerable to any greater-than-expected Fed tightening.

3. Build portfolio resilience.

Broad market draw-downs have become more frequent in 2018 as volatility has risen from the doldrums of 2017. Many market segments have fallen sharply, from financial stocks and crypto currencies to perceived safe-havens such as telecom stocks. We would be wary of assets seeing sharp price rises that are disconnected from fundamentals. We prefer a barbell approach: exposures to government debt as a portfolio buffer on one side and allocations to assets offering attractive risk/return prospects such as quality and EM stocks on the other. This includes steering away from assets with limited upside if things go right, but hefty downside if things go wrong. We see European equities and European sovereign bonds falling into this category.

2 things we learned in 2018

1. Corrections still happen

Entering 2018, it was easy to forget that markets actually can and do go down. The S&P 500 had held below its long-term average volatility for the previous six years, and hadn’t dealt investors a 10% decline in almost two years. In 2018, we saw two such corrections – the first beginning in late January and the second in early October. The first was hard to react to. It lasted only nine days, and quickly reversed as the market reached new highs in the subsequent months. Advisor models weren’t defensively postured entering the year, and it turns out they didn’t need to be for that first correction.

The second correction was more significant–not in magnitude but in the way it eroded confidence. As the year ends, we notice that, compared to earlier in the year, advisors are more concerned about global trade issues and less certain about where we are in the market cycle.

In the past, our stress test analysis of all ten thousand models suggested advisors had client portfolios well-positioned for further economic growth (the right call), but not well-positioned for a recession. If the collective views of the advisors we work with are shifting, we should expect advisor models to demonstrate that change. While we’ve learned that corrections do still happen, we haven’t seen much evidence that advisors are doing much about them….yet.

2. Cash can actually produce yield

A key story line this year has been the rise in yields of short maturity bonds and cash-like instruments. However, although the inflation-adjusted yields on short maturity bonds are positive for the first time in years, they are still not likely enough to sustain most investors in the long run.

Considering bond portfolios in isolation, advisors are right to shift into shorter maturity bonds, which now yield almost as much as longer maturities do. We do find short-term bonds attractive today, and the increased yields now available offer a buffer in case rates continue to rise. However, almost every model in our data contains stocks, and the decisions you make in managing bonds in isolation are different than those you make while also managing equities. As we approach the ninth rate hike into a Fed tightening cycle, we believe investors can be a bit less concerned about losing money in bonds, and a bit more comfortable adopting a conventional view that bonds can diversify the risk of your stocks falling.

2 things we’d do in 2019–A potentially more difficult year

1. Get properly diversified

If the corrections of 2018 remind us of anything, it’s that we cannot ignore the importance of diversification in building resilient portfolios. We likely need to own some (not necessarily a lot) of what makes us uncomfortable; this is where real diversification comes from. Ask yourself, “If the markets moved in the opposite direction from the way I think, will any of my investments do well? If you feel good about everything in your portfolio simultaneously, then you aren’t likely well-diversified.

At a minimum, re-balancing your portfolio should help. However, considering that the market environment may be shifting, re-allocating your portfolio may be what’s needed. This is not to suggest shifting assets from stocks to bonds, nor going to cash – your long term asset allocation is critical to reaching your investment goals. Rather, it may be time to consider owning different things within the stock and bond sleeves, particularly things that improve the diversification of each sleeve or the portfolio as a whole.

2. Manage investing emotions

The more volatile the market events, the more emotive the human response. Successful investing avoids emotional overreactions to any one bad day, bad monthly statement, or a poor result from a bad stock pick. Turning off the television can help.

Try to envision a larger picture. There have always been volatility spikes in markets, and there likely always will be. Successful investors understand how to navigate the emotions that come with them.

Preparation is important. If you suspect the market environment may be shifting in the coming year, simulate that now, and decide what things you plan to add to the portfolio (along with the things you plan to remove). If you can, stress test both portfolios to ensure your changes will give you the shift in outcomes you seek.

If market volatility starts to make you nervous, ask yourself an important question; “Am I bearish or am I uncertain?” Don’t confuse the two. If you are bearish, then make the portfolio more conservative. But if you are uncertain, then don’t make big bets in either a bullish or bearish direction. Importantly, uncertainty should lead your portfolio weights back to your strategic asset allocation–not to cash.

Being under-risked can be as problematic as being over-risked. There’s no reason to be either while you are under-confident.

Bottom Line

As we prepare for the ball to drop in Times Square, it’s a great time to take stock of your portfolio. At moments of uncertainty, it’s important to simplify your process, reduce the size of your bets, and don’t get hung up on the last 10 years as if it’s the only type of market that can exist.

Shifting your focus to regimes–not weeks or months–can allow you to stay nimble, play defense if needed, and capitalize on the next market environment as it begins to develop.

Patrick Nolan is the Portfolio Strategist within BlackRock’s Portfolio Solutions group. He is a regular contributor to The Blog.

Where to next? Roughly 100 BlackRock investment professionals recently gathered for two days to talk markets and the outlook for 2019. A major takeaway from our discussions: Three themes are likely to shape markets in 2019, as we write in our 2019 Global investment outlook.

Theme 1: Growth slowdown

We see a slowdown in global growth and corporate earnings in 2019, with the U.S. economy entering a late-cycle phase. Our BlackRock Growth GPS has been trending lower across the U.S. and euro-zone, pointing to a slower pace of growth in the 12 months ahead. We see U.S. growth stabilizing at a much higher level than other regions, even as the fading effects of domestic fiscal stimulus weigh on year-on-year growth comparisons. This underscores our preference for U.S. assets within the developed world. We expect the Chinese growth slowdown to be mild, as the country appears keenly focused on supporting its economy via fiscal and monetary stimulus.

Slowing growth and the impact of tariffs make for a more cautious corporate outlook, with global earnings growth likely to moderate. In the U.S., the expected slowdown partly reflects a higher hurdle versus 2018 when corporate tax cuts provided a big boost to company earnings. U.S. earnings growth estimates look set to normalize from a heady 24% in 2018 to 9% in 2019, consensus estimates from Thomson Reuters data show. This is still above the global average. Emerging markets (EM) are set to maintain double-digit earnings growth, led by China as its tech sector recovers and a pivot toward economic stimulus supports its economy. The U.S. and EMs remain our favored regions, as we see U.S. and EM companies best positioned to deliver on expectations. Yet we expect muted returns for both stocks and bonds in 2019 against a backdrop of slowing growth.

Theme 2: Nearing neutral

We see the process of tightening financial conditions pushing yields up (and valuations down) set to ease in 2019. Why? U.S. rates are en route to neutral—the level at which monetary policy neither stimulates nor restricts growth ­—and the Federal Reserve looks likely to pause its tightening process. Our analysis pegs the current U.S. neutral rate at around 3.5%, a little above its long-term trend. While uncertainty abounds over where neutral lies in the long run, our estimate sits in the middle of the 2.5% to 3.5% range identified by the Fed. We currently see a rate near the top of this range needed to stabilize the U.S. economy and debt levels. Yet we expect the Fed to become more cautious as it nears neutral. As a result, we expect the FOMC to pause its quarterly pace of hikes amid slowing growth and inflation in 2019. We see the pressure on asset valuations easing as a result. Europe and Japan will likely take only timid steps toward normalization. We don’t expect the European Central Bank to raise rates before President Mario Draghi’s term ends in late 2019.

Theme 3: balancing risk and reward

Recession fears are joining trade as a key market worry in 2019. Markets are vulnerable to fears that a downturn is near, even as we see the actual risk of a U.S. recession as low in 2019. Still-easy monetary policy, few signs of economic overheating and a lack of elevated financial vulnerabilities point to ongoing economic expansion in 2019. Yet the odds are set to rise steadily thereafter by our analysis, with a cumulative probability of more than 50% that recession strikes by end-2021. See the chart below.

Trade frictions and a U.S.-China battle for supremacy in the tech sector also loom over markets. We see trade risks more fully reflected in asset prices than a year ago, but expect twists and turns in trade negotiations to cause bouts of anxiety. Increasing uncertainty points to the need for quality assets in portfolios—but also potential for upside should market fears about trade ebb in 2019.

We advocate a barbelled approach for carefully balancing risk and reward: exposures to government debt as a portfolio buffer, twinned with high-conviction allocations to assets that offer attractive risk/return prospects. Quality has historically outperformed other equity style factors in economic slowdowns, our analysis shows. We see EM equities as good candidates for the other end of the barbell. What to avoid? Assets with limited upside if things go right, but hefty downside if things go wrong. We see many credit and European assets falling into this category.

Common gauges—which include interest rates, market volatility and asset valuations—can give misleading results. This is because unadjusted financial asset prices tend to both reflect growth news as well as drive growth news. Take the following example: Rising U.S. growth expectations can push up yields and the dollar. This could lead to the deceptive conclusion that financial conditions are tightening and the growth outlook is deteriorating. Most common gauges account for the impact of the business cycle thus far on financial asset prices, but they do not account for the fact that current economic expectations also affect today’s asset prices and hence financial conditions.

Financial Conditions Indicator (FCI)

Our latest Macro and market perspectives, A tale of tighter conditions, introduces our Financial Conditions Indicator (FCI)–a better gauge of financial conditions, we believe, than common measurements. Our new FCI seeks to avoid the problem of common gauges by fully stripping out the impact of growth news on asset prices from the underlying asset prices for government bonds, corporate credit, equity markets and the exchange rate. Once the forward-looking factor is also removed, our FCI behaves more closely in line with economic theory. Case in point: an increase in interest rates and yields following better growth news does not lead to an assessment by our metric that financial conditions have tightened.

Our FCI provides a measure of the impact that financial conditions are exerting on the growth outlook–as proxied by the BlackRock Growth GPS–and not the impact of the current growth outlook on financial conditions. Its inputs include policy rates, bond yields, corporate bond spreads, equity market valuations and exchange rates.

What is our new FCI telling us?

It shows financial conditions in the U.S. and in the euro-zone are tightening. Moves in our FCI have historically led our growth GPS by around six months. Tighter financial conditions suggest that growth in the U.S. will likely decelerate in the coming twelve months. See the Tighter times chart.

All other things equal, this implies slowing, but above-trend global growth in 2019, we believe. The sell-off in financial markets since the summer and ongoing Fed policy tightening would be consistent with U.S. gross domestic product (GDP) growth slowing to just under 2.5% next year from almost 3% now. The market sell-off since September has alone caused a tightening in financial conditions equivalent to a 35 basis point decline in the U.S. Growth GPS.

What does our FCI say about monetary policy?

In September the median Fed projection was for four more rate hikes by the end of 2019. Our FCI suggests this would tighten financial conditions enough to arrive at 2% growth by 2020–assuming that no other factors weigh on growth. But the fading fiscal stimulus boost–which alone could lower U.S. GDP growth by 25-75 basis points, according to our estimates–and elevated trade tensions will likely also weigh on growth, reducing the scope for Fed rate hikes, we believe. And another financial market sell-off could further tighten financial conditions.

We believe monetary policy tightening–beyond that priced by the market–would only be required to engineer a “soft landing” if no other headwinds slow growth down to around 2%. Growth at 2% is the level that we and the Fed believe to be sustainable because it is closer to the pace of growth of potential output.

In the euro-zone, our FCI suggests a substantial slowdown in GDP growth to less than 1.5% next year–financial conditions are already tight enough for growth to moderate to a level close to potential. We believe this implies that the European Central Bank (ECB) may decide to keep interest rates at record lows for most of 2019. But fiscal stimulus by several member states could also support euro-zone growth, potentially changing the picture for the ECB.

Bottom Line

Our FCI–like other daily gauges of financial conditions–is currently based on a small set of financial market variables so it can be updated on a daily basis. But financial conditions are also represented by other information that includes surveys of credit conditions, interest rates charged and paid by banks, and the amount of financing that is being made available to the private sector. These factors should also be considered in assessing financial conditions. Read more on our research in our latest Macro and market perspectives.

Elga Bartsch, Head of Economic and Markets Research for the BlackRock Investment Institute, is a regular contributor to The Blog.

A U.S. recession is not imminent, in our view, yet trade-related uncertainty and fears of a slowdown are challenging for risk assets. Recent inversion in parts of the U.S. Treasury yield curve has some investors worried. They point to historical incidents when curve inversion has foreshadowed recessions. We caution against that view. Our analysis would put recession probabilities as low for 2019 but rising to just above 50% by the end of 2021. We find equities have historically done well in late-cycle slowdowns. This includes even the calendar year preceding an economic downturn, as shown in the chart. Equity performance generally deteriorated as recession drew nearer, with U.S. Treasuries taking the lead as investors turned to perceived “safe havens.” History may not repeat. The averages mask a wide range of market outcomes around recessions given differences in starting valuations and the character of each downturn. Yet history often can be informative.

Renewed focus on portfolio ballast

Still-easy monetary policy, few signs of economic overheating and a lack of elevated financial vulnerabilities point to ongoing economic expansion. Yet the U.S. economy is entering a late-cycle phase, and the likelihood of temporary risk-off events is higher with elevated uncertainty. Trade frictions and a U.S.-China battle for supremacy in the tech sector hang over markets. We see trade risks more fully reflected in asset prices than a year ago, but expect the twists and turns of trade talks to cause bouts of anxiety. And we worry about European political risks in the medium term against a weak growth backdrop. Read more in our 2019 Global investment outlook.

As a result, we see U.S. government bonds playing a greater role in portfolios. For one, they can help cushion against any late-cycle selloffs of risk assets. In addition, the Federal Reserve’s policy path may create a relatively benign environment for Treasuries. We see the Fed pausing its rate-hiking cycle at some point in 2019 to assess the effects of slowing economic growth and tightening financial conditions.

We prefer short- to medium-term bonds. Higher yields and a flatter curve as a result of the Fed’s rate increases over the past three years have made shorter maturities an attractive source of income for U.S. dollar-based investors. Short- to medium-dated Treasuries now offer nearly the same yield as the benchmark 10-year Treasury, we find. Core European government bonds (such as German bunds) appear less attractive, as the European Central Bank’s still-easy monetary policy pins down their yields at low levels.

Bottom line

Rising risks call for carefully balancing risk and reward: exposures to government debt as a portfolio buffer, twinned with high-conviction allocations to assets that offer attractive risk/return prospects such as EM equities. We prefer stocks over bonds, but our conviction is tempered. In equities, we prefer quality—free cash flow, sustainable growth and clean balance sheets. We favor up-in-quality credit. We steer away from areas with limited upside but hefty downside risk, such as European stocks.

Back in August I highlighted the potential for economic deceleration. At the time I highlighted three warning signs: weakness in non-U.S. economies, negative economic surprise indexes and softer manufacturing and housing. Unfortunately, the last three months seem to have confirmed the early warning signs.

1. Global manufacturing looks to have peaked.

It now looks even more likely that global manufacturing peaked in early 2018 (See Chart 1). Moreover, while China and Europe rolled over earlier this year, the United States is no longer immune. The ISM New Orders Index, a good leading indicator for manufacturing and the broader economy, is slipping: It is now at its lowest level in 18 months, before the “sugar-high” of last year’s tax cut, although it is still comfortably over 50.

2. Financial conditions are getting tighter.

Higher rates, a stronger dollar, a more volatile stock market and less benign credit markets equal more expensive and less available money, i.e. a tighter financial conditions. This is evident in a number of indicators, including the Goldman Sachs Financial Conditions Index (GSFCI). Tighter financial conditions don’t just impact financial assets, but also the real economy. As borrowing costs rise, confidence is challenged and credit growth decelerates.

3. Housing is looking ever more challenged.

Regardless of the metric you pick, U.S. housing is softening. Prices and sales are decelerating, while starts and building permits are both weakening. This is important for two reasons: Housing tends to have a “multiplier effect” on other consumption and it often leads the broader economy.

4. Shifting preferences

To be clear, there are few obvious signs of an imminent recession. Household consumption has been uncharacteristically strong, at least relative to the post-crisis environment. Fourth quarter growth is still expected to come in at a relatively healthy 2.5%. The problem: That is probably as good as it gets for a while. A growing conviction in a slowdown is clear in recent investor behavior.

During the past three months, cyclical sectors, such as energy, materials and technology, have fallen by at least 10% (Source: Bloomberg, as of 11/27/18, based on relevant S&P sector indexes). Conversely, more classic defensive sectors, notably utilities and consumer staples, have defied the broader market and posted positive gains. Nor is the trend limited to stocks. In contrast to the pattern earlier in the year, growth sensitive bonds– i.e. high yield — have been under pressure as well. At the same time, investors are starting to be tempted by traditional, safe-haven bonds. After soaring earlier in the year, long-term Treasury yields have been contained in recent months.

To the extent growth is likely to decelerate further from here, I would continue to lean towards lower-beta, i.e. more defensive stocks, along with a greater emphasis on quality. I would define the latter as companies with low leverage and the ability to maintain pricing power and earnings. The hope is that these segments of the market provide for a more robust portfolio, even if “peak growth” morphs into the “R” word.

Large institutional investors have been big adopters of bond ETFs. As Greenwich Associates found in their new report, 60% of institutions in the U.S. and Europe have increased their use of bond ETFs in the past three years, with an average allocation of 18% to their fixed income portfolios.

A changed bond universe

One of the major forces driving the move to ETFs is the evolution of the bond market since the financial crisis. Heightened capital requirements have made it more expensive for dealers to hold bonds in inventory. As a result, despite the growing U.S. bond market, it has become more challenging for institutional investors to source the fixed income exposures they need. Indeed, two-thirds of institutional investors have felt the impact of diminished liquidity on their investment management process.

So how are large institutions navigating this new bond market? Enter the fixed income ETF. On the market since 2002, the structure allows investors to trade bonds on exchange, like a stock ETF, thus offering multiple layers of liquidity through primary and secondary markets.

78% of institutional investors also cited the operational efficiency of the ETF structure. Bond ETFs make it possible to gain near immediate exposure to a portfolio of securities in a single line item, without the operational costs and complications of chasing down single bonds. For example, the iShares Core U.S. Aggregate Bond ETF (AGG), has over 6,800 holdings and a net expense ratio of just 0.05%.1 Acquiring that many bonds would be unimaginable even for a large institution. Even if an investor could track down the bonds, the transaction costs would be overwhelming.

An all-purpose vehicle

With over 350 fixed income ETFs currently offered in the United States, investors are most likely able to find a fund to fit their needs. Whether for broad market exposure or niche tactical plays, the motives for using ETFs are consistent.

Fixed income ETFs aren’t just for big investors; they have democratized the markets for all investors by making bonds easier to access than ever before. Now anyone can invest like a professional.

Matt Tucker, CFA, is the iShares Head of Fixed Income Strategy and a regular contributor to The Blog.